Policy instruments to avoid output collapse: an optimal control model for India

Abstract

This paper identifies the key policy instruments to be monitored in order to avoid output collapse in the short run for developing countries that come under the IMF-supported adjustment programmes. Changes in exchange rate and aggregate domestic credit are the standard instruments in a Fund-supported policy package used to target balance of payments (BOP) improvement and inflation reduction. Within a small macroeconometric policy-oriented model of India, this paper carries out optimal control exercises to obtain optimal policies for desired targets. The analysis thus carried out indicates that demand contraction based on domestic credit restriction leads to improvement in the BOP and reduction in inflation rather than increased output. This paper suggests using instruments such as credit flow to the private sector on the monetary side, and public spending on basic infrastructure on the fiscal side, so as to make adjustment programmes growth-oriented even in the short term.

Acknowledgements

This paper has been derived from the Author's Ph.D. research at the University of Warwick. The author thanks Kenneth F. Wallis, T. Krishna Kumar and Santonu Basu for their useful comments and Peter R. Mitchell for his help on optimal control solutions. Any remaining error is the author's alone.

Notes

¹ Large negative output gap or excess capacity means low inflation. This is partially reflected in relatively low inflation rates of 10% in low-income countries, compared to 50% inflation rate in middle- income countries, while high-income countries have annual inflation of 1.5% mainly due to their policy towards containing inflation (Source: World bank for 2001). India is a low-income country as per the World Bank's definition.

² For an overview of different approaches to policy making, see Wallis (1995).

³ Small- and medium-sized enterprises (SMEs) potentially constitute the most dynamic firms in an emerging economy. Lack of finance is the main obstacle to the growth of SMEs. Among other factors, key obstacles for SMEs include limited access to working capital and long-term credit, inadequate infrastructure, and high transaction costs.

⁴ A more detailed list of variables used and their definitions and sources of data are provided in Mallick (2004 and 2002).

⁵ Chand and Sen (2002) find that the trade reform in Indian manufacturing has had a positive impact on total factor productivity growth, but it still remains a controversial issue being time- and sector-dependent (such as final- or intermediate-goods sectors). In general, with regard to the empirical evidence on a cross-country basis, the linkage between trade liberalization influencing growth has been mixed, with studies supporting the nexus (for example, Greenaway et al ., 2002), and others being sceptical of the relationship (for instance, Rodriguez and Rodrik, 2000).

⁶ Real interest rates tend to be relatively high in DEs undertaking adjustment programs involving monetary stringency. Since it is not our purpose in this paper to model the impact of financial liberalization, we would like to be modest with regard to our results.

⁷ It should, however, be noted that in a model with a quadratic objective function only the necessary conditions, or first-order conditions, give rise to a system of simultaneous linear equations that will have unique solutions only if this condition is satisfied. If the objective function is in general non-linear and not quadratic, this condition may not hold.

⁸ The fiscal deficit continues to overshoot the budget assumptions by a large margin, which remains a cause for serious concern, as it is squeezing liquidity in the market. And, structural rigidity in government current spending makes it difficult to slash the deficit as targeted in each year's budget.

⁹ The government of India has placed a high priority on market-driven policy reforms. At the same time there has been a gradual withdrawal of budgetary support to PEs encouraging such enterprises to tap the capital market.

¹⁰ In the decade 1991–2000 the government could manage to get 40% of what it targeted in privatization proceeds so as to contain the fiscal deficit (Source: CMIE).

¹¹ The combined central and state government deficits currently exceed 10% of GDP, threatening a broader economic crisis.

¹² This feature of ‘exchange rate pass through’ phenomenon has also been examined in a recent disaggregated trade model by Krishnamurty and Pandit (1997).